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Executive Compensation: Governance and the Financial Crisis

Abstract and Keywords

This article provides a broad discussion of executive compensation and incentives, investigating whether outcomes are consistent with economic theory. The rest of this article is organized as follows. It discusses various economic approaches to executive pay. Then it investigates factors that have been driving the growth in CEO compensation. It provides a commentary on executive compensation and the recent financial crisis. A final section offers some concluding remarks.

Keywords: executive pay, CEO compensation, financial crisis

The 2008 financial and economic crisis catapulted executive compensation into the spotlight. Interest in CEO pay is unprecedented. Regulators, politicians, the public, the media, and some academics have frequently been highly critical of executive pay practices—especially at banks and financial institutions.1 Authorities in the United States and around the world are seeking ways to improve the system of executive compensation and associated corporate governance arrangements. In the United States, the 2010 Dodd-Frank Act was the outcome of the financial regulatory reforms of President Barack Obama's administration. It creates new rules for executive compensation and corporate governance. The goal of this chapter is to provide an overview of executive compensation practices and give some guidance on the reasons why pay has increased. In addition, the chapter considers executive compensation issues in the light of the financial crisis.

At least three factors are driving the unprecedented recent interest in CEO pay. First, even as the economic recession deepened, Wall Street bankers appeared to be making even higher compensation. In 2009 Merrill Lynch allocated $3.6 billion in bonuses to its employees, and at American International Group (AIG) $218 million was paid in bonuses to employees of its financial services division. The public was outraged, especially as many of these firms were relying on taxpayer dollars for their continued survival. Second, many CEOs do receive very large amounts (p. 372) of money, and the dollar amounts can attract significant attention. The median CEO in the S&P 500 earned about $8 million in 2008. Annual growth rates in CEO pay can often exceed 10 percent. Critics also contend that CEO compensation is not sufficiently tied to the performance of their firms. Worse still, CEOs often receive high pay when company performance goes down, creating the impression that they are “rewarded for failure.” Third, U.S. CEOs earn significantly more than the typical American employee. In 1993, CEO pay was approximately 100 times higher than median household income. By 2006 it was more than 200 times higher (Kaplan, 2008). Growing income equality has sparked considerable interest in executive compensation.

There are two broad and essentially competing perspectives on executive compensation. The first is “optimal contracting” theory. According to this perspective, markets ultimately determine executive compensation. CEO pay arrangements, although not always perfect, reflect the (marginal) costs and benefits of arm's-length bargaining between boards and CEOs. Executive pay contracts provide efficient incentives for dealing with agency costs (Core and Guay, 2010a; Holmstrom, 1979). Agency theory is at the heart of the optimal contracting approach and is the standard economic approach to understanding executive pay (Murphy, 1999). The second perspective is the “managerial power” theory. It claims that executive pay arrangements are not the outcome of arm's-length contracting. CEO pay arrangements are fundamentally flawed, and managerial excess is widespread. This view sees executive compensation as part of the corporate governance problem, rather than the solution to it (e.g., Bebchuk and Fried, 2004). According to this approach, CEOs have significant power over pay-setting institutions (such as boards of directors, remuneration committees, and pay consultants) and use this power to influence pay arrangements in their favor.

This chapter provides a broad discussion of executive compensation and incentives, investigating whether outcomes are consistent with economic theory. The rest of this chapter is organized as follows. The next section discusses various economic approaches to executive pay. Then I investigate factors that have been driving the growth in CEO compensation. I provide a commentary on executive compensation and the recent financial crisis. A final section offers some concluding remarks.

Setting Executive Pay

The goal of a well-designed compensation contract is to align the interests of the CEO and the firm's owners (Murphy, 1999). The firm needs to attract, retain, and motivate talented executives. In theory, shareholders set pay. In practice, the board of directors sets pay, ostensibly acting faithfully on behalf of the company shareholders. If the board fails in its fiduciary duties of care and loyalty to the principal, (p. 373) this can lead to poorly designed compensation contacts. Indeed, much of criticism of executive pay focuses on alleged board ineffectiveness in the face of too powerful CEOs. If boards fail, then excess pay and too lax incentives may result (Bebchuk and Fried, 2004, 2005).

The economics of executive compensation is generally motivated by principal agent considerations (Holmstrom, 1979). A risk-neutral owner and rational self-interested utility-maximizing CEO is assumed. There is an asymmetry of information between the owner of the firm (the principal) and the CEO (the agent) who makes decisions on behalf the owner.2 This gives rise to a moral hazard problem, namely, that the actions or care taken by the CEO are not perfectly observable, at zero or low cost, to the owner. The CEO can opportunistically pursue his3 own interest at the expense of shareholders because he is better informed about his own actions. Practically, moral hazards come in many forms. First, the CEO can enjoy the quiet life by picking easy-to-manage tasks. A risk-averse CEO may avoid undertaking risky projects with positive net present values, especially if the ex post outcomes of such projects turn out to be poor and lead to termination. Second, the CEO may engage in self-interested empire building. One mechanism to achieve this is via mergers and acquisitions. Mueller's review (chapter 15 in this volume) concludes that on average mergers do not increase efficiency, but instead ultimately destroy wealth for the acquiring firm's shareholders. Given that salaries are often strongly linked to firm size, CEOs have incentives to engage in mergers, even mergers that may not be in the owners' interests. Third, the CEO may make excessive or unwarranted use of company perks that may not be beneficial for shareholders. This may include excessive use of corporate aircraft, financial services, or club memberships. In the extreme, moral hazard also includes intentional misappropriation of shareholder funds, including fraud and theft. Corporate accounting scandals such as Enron, or the Ponzi scheme perpetrated by former investment banker Bernard Madoff are (unfortunately) prime examples of unethical behaviors.

One solution to the myriad potential moral hazards is for the firm's owners to design a contract that makes management rewards contingent on performance. In this context, the CEO chooses the correct (i.e., optimal) action (focuses on increasing firm performance) because it is in his best interests to do so (for example, it leads to greater individual wealth). Others are less sanguine about the current state of affairs. Morck and Yeung (chapter 12 in this volume) state that the “institutions surrounding corporate governance is clearly incomplete, for most countries employ regulations that are both costly and largely ineffective.” However, they point to examples from the political science literature that are optimistic that institutional reforms of corporate governance mechanisms will arise and lead to better outcomes in advanced capitalist economies.

Agency theory, then, provides the underlying logic for “pay-for-performance” plans in organizations (Murphy, 1999). Theory predicts that executive pay contracts include instruments such as stock options, accounting earnings, and individual performance metrics that provide a valuable signal of the executive's effort. This is the optimal contracting approach to executive pay. Two points are worth (p. 374) noting. First, the agency model predicts that second-best contracts reduce opportunistic behavior. The use of compensation such as stock options motivates CEO effort to increase stock prices. Second, agency costs are not completely eliminated. Instead, the firm evaluates the incremental benefits and costs of designing, implementing, and verifying the contract. Exogenous changes in the firm's environment (e.g., regulation, change in technologies) can alter the marginal costs and benefits that the board faces, leading to potentially better contract design (Core and Guay, 2010a). In addition, the optimal contract may change over time. Improvements in board governance arrangements (e.g., the addition of high-quality independent directors) may lead to reoptimization of contracts by the boards and hence to different patterns of executive compensation and incentives.

A popular alternative view is that CEOs set pay in their own (rather than shareholder) interests. It has been termed the managerial power view (or sometimes “skimming” hypothesis) and contrasts with optimal contracting theory (Bebchuk and Fried, 2004; Bertrand, 2009). It argues that bargaining between corporate boards and CEOs is not arm's length and executive pay is excessive. The resulting pay contracts are not in shareholders' interests. How might this come about? One version of the theory is that CEOs exercise significant power and influence over the board and use this to lobby for high pay levels. The excess pay constitutes an economic rent, which is an amount greater than that required for the CEO to provide labor services to the firm. There are limits or constraints on how high CEO pay can be. Too much compensation can ultimately damage an executive's reputation or cause embarrassment (e.g., via adverse media exposure or annual shareholder meetings). Bebchuk and Fried (2004) call this phenomenon “outrage costs.” The “outrage” matters because ultimately it can impose market penalties on CEOs (such as devaluation of a manager's reputation) as well as social costs. They argue that market constraints and the social costs coming from excessively favorable pay arrangements are not sufficient in preventing significant and widespread deviations from optimal contracting.

Executive Compensation Structures

Executive compensation typically contains four broad elements: an annual salary, an annual bonus, equity compensation in the form of stock options and restricted stock, and other benefits in the forms of retirement pay and perks (Murphy, 1999). In the United States, changes in disclosure requirements in 1992 led to significantly enhanced information about salaries, options, and bonuses reported in proxy statements. Disclosure was enhanced in other countries too. In the United Kingdom, the Cadbury Report in 1992 ushered in a new era of governance leading to greater pay disclosure from 1995 onward. In continental Europe and parts of Asia, disclosure of executive compensation is less complete, but progress is being made. The core structure of the Cadbury Report (or similar recommendation) is increasingly being adopted in many countries, and transparency of executive pay is getting better. (p. 375)

A central component of CEO pay is the base salary. CEO salaries are determined annually and are not mechanically related to firm performance, such as stock returns. Two points about salaries are worth emphasizing. First, CEO salaries are strongly correlated with firm size. Research suggests that an increase in firm size of 50 percent can increase CEO pay by approximately 20 percent. The elasticity of executive pay to firm size is often estimated in the range of about 0.2 to 0.4 (Murphy, 1999). It is regularly interpreted as the economic returns to managerial talent, as larger firms require better managers to run them. However, it also implies that CEOs have incentives to increase firm size, even if this is not in the interests of owners. For example, CEOs might engage in merger and acquisition activities even if these are not profitable (see chapter 15). Second, firms set CEO salaries by benchmarking to other similar CEOs using survey data and professional advice from pay consultants. Consultants label salaries at or above the median as “competitive” and those less than the median as “below market.” This can lead to unintended (but nevertheless predictable) consequences. First, salaries might ratchet upward as firms avoid the uncompetitive (below median) part of the executive pay distribution. Second, if a self-interested CEO can exert inappropriate influence over the board's compensation committee, the consultants, or the choice of peer firms, then CEO salaries can be driven up beyond what is optimal for shareholders.

CEOs also receive annual incentives—a bonus that is generally paid in cash. The performance measure triggering the bonus is usually an internal company accounting variable, such as budgeted earnings. External or market-based performance measures such as stock returns or share price returns relative to the market are rarely used in driving bonus pay—internal accounting measures are predominant (Murphy, 1999). The expected payment (i.e., the typical payoff schedule) for CEO bonuses is nonlinear. Below some threshold performance level the CEO receives nothing, above this trigger there is a pay-for-performance zone where increases in performance translate into higher pay, and then at some upper performance level bonus payments are capped.4 Two important points are worth emphasizing. First, a central problem with this type of payoff schedule is that it may encourage strategic behavior by the executive. Those who design the plan do not intend this gaming, but it is predictable if the CEO is rational. For example, executives have few incentives to increase effort beyond the pay cap. This encourages the CEO to focus on activities that postpone revenue recognition (e.g., inventories) or accelerate cost recognition (e.g., write downs or R&D expenditures). For performance levels significantly below the minimum level that triggers the bonus, the plan participants might engage in “big-bath” accounting because the probability of achieving the minimum performance standard is unlikely. Second, the CEO may lobby for a softer performance target or more easily obtainable performance metric. The main point is that the typical CEO bonus plan, found in many companies, can easily lead to unintended but nevertheless predictable CEO behavior, such as strategic manipulation of the plan or gaming.

A major element of executive compensation is stock options and other forms of equity compensation such as restricted stock (Core et al., 2003; Murphy, 2009). (p. 376)

Stock options are the right but not the obligation to purchase a share in the firm at some prespecified price at some date in the future. Restricted stocks are shares given to an executive (or cash equivalents) contingent on some restriction being met. For example, the recipient may have to meet a financial performance target, or there might be a time restriction before the options vest. The use of stock options, as a central form of executive compensation, expanded greatly in the 1990s. Research shows that perhaps up to 50 percent of a CEO's total pay came in the form of options by the late 1990s (Murphy, 1999). Stock options became increasingly common in parts of Europe, too, especially the United Kingdom (Conyon and Murphy, 2000). Stock options were a less popular compensation instrument in continental Europe and do not appear to have had as long a history as in the United States.

Stock options are usually valued as the economic cost to the firm of granting an option to an employee. This is the opportunity cost to the firm that is forgone by not selling the call option in the open market. The expected value can be obtained by using the Black and Scholes (1973) model, including dividend payments by Merton (1973). The price of a European call option on a dividend paying stock is c = Se-qtN(d1) – Xe-rtN(d2), where d1 = (ln(S/X) + (r – q + σ2/2)t)/σ√t, d2 = d1σ√t, and S is the stock price, X the exercise price, t the maturity term, r the risk-free interest rate, q the dividend yield, and σ the volatility of returns. N(.) is the cumulative probability distribution function for a standardized normal variable (Black and Scholes, 1973). Given some reasonable values for the input variables (i.e., the risk-free rate, dividend yield, stock volatility), a call option on a stock whose current face value (i.e., price) is $100 has an expected value of about $13.5.5 The price of a stock option granted to an executive is generally about 30 percent to 50 percent of the face value of the stock,6 and the value of all options granted to the CEO in a given period is simply the sum of the excepted value of each option grant. Stock options given to executives are normally granted “at the money,” such that the exercise price is set equal to the stock price. In addition, options might have a three-year period before they vest (i.e., when ownership is transferred to the executive). Once vested, the typical exercise window is usually between three and ten years, at which time the option contract matures. Because options can be granted annually, the executive can build up a considerable stash of stock options over time.

Two features about stock option pay should be emphasized. First, many assumptions underlying the Black-Scholes model are unlikely to hold in practice, meaning the recipient of the option will place a different value on it compared to the firm. Executives are typically risk-averse, undiversified, and prevented from trading their options or, indeed, hedging their risk by selling short company stock. In consequence, they will place a lower value on the stock option compared to the Black-Scholes cost to the company. Second, the difference in valuations between the firm and the option recipient can be thought of as a premium that the firm must pay employees to accept the risky option versus cash compensation. Firms will want to make sure that the resulting increase in executive and firm performance from using options covers the premium. In this sense, stock options are (p. 377) an expensive way to reward executives compared to simply providing cash to the executive. However, the use of options is warranted if they generate sufficient extra effort or performance by the executive. There is currently little field, experimental, or other empirical evidence on precisely how executives attach value to their stock options. An exception is Lambert and Larcker (2001), who find that employees often do not value options in accordance with the standard Black-Scholes model. In addition, they hold unrealistic expectations about what will happen to the future stock price. More research in this area is required. If options are expected to really motivate CEOs and align their interests to owners, then presumably executives must attach significant value to them. If not, the legitimacy of options as a motivational tool is questionable. Despite these limitations Black-Scholes pricing strategies are routinely used by firms as a way of arriving at the expected value of an option.

The Growth in Executive Pay

Many studies have demonstrated that U.S. CEO pay increased dramatically from the late 1980s and early 1990s (Core and Guay, 2010a; Kaplan, 2008; Conyon, 2006; Murphy, 1999; Hall and Liebman, 1998). Many studies focus on the United States partly because of the availability of a relatively long time series of high-quality data, and because U.S. executives are thought highly paid compared to their European counterparts. Total CEO compensation is usually measured as salary, bonus, long-term incentive payouts, the value of stock options granted during the year (valued on the date of the grant using the Black-Scholes method), and other cash payments (including signing bonuses, benefits, tax reimbursements, and above-market earnings on restricted stocks). This is a flow measure of executive pay, capturing compensation received by the executive in a given year. However, pay is different from CEO wealth held in the firm, which also includes the value of stock and options that have been granted in previous periods. Making the distinction between CEO firm wealth and pay in providing the executive with incentives is critical (Core and Guay, 2010a).

Empirical evidence on CEO pay is provided in figure 13.1 for the constituents of the S&P 500. It shows that average and median CEO pay increased significantly over time. Median pay is below average reflecting an important characteristic of the CEO pay distribution—CEO pay is positively skewed and has a long right tail. This means that most CEOs earn relatively low compensation, and a few in the right tail receive excessively generous rewards. The notion that all CEOs receive stratospheric sums is inaccurate. CEO pay increased significantly over the period 1992 to 2008. Median pay increased about threefold. Notice, however, that average pay fell from about 2000, reflecting market declines and the dot-com crash.

 Executive Compensation: Governance and the Financial Crisis

Figure 13.1. CEO Pay in S&P 500 Firms between 1992 and 2008

Notes: The data source – Standard & Poor's ExecuComp Database. Total CEO compensation is measured as salary, bonus, long-term incentive payouts, the value of stock options granted during the year (valued on the date of the grant using the Black-Scholes method), and other cash payments (including signing bonuses, benefits, tax reimbursements, and above-market earnings on restricted stocks). ExecuComp data item TDC1 is used.

Subsequently pay has increased. One important reason that CEO compensation increased at this time was the willingness of firms to grant stock options (Murphy, 1999). Table 13.1 contains data and evidence produced by Core and Guay (2010a). They show that median CEO pay in the S&P 500 firms increased (p. 378) from approximately $2 million in 1993 to about $7.7 million in 2008, and the annual rate of growth in pay was approximately 9.4 percent. Total annual pay is calculated as the sum of salary, bonus, the value of stock and option grants, and other pay in the year. Core and Guay further show that the growth in CEO pay (9.4 percent) is positively correlated with growth in firm market values over the period 1993 to 2008 (10.1 percent) and that CEO pay as a fraction of firm market value has remained approximately constant over time. This is consistent with Gabaix and Landier (2008), who predict that CEO pay is explained by the growth in firm size.

The exceptional growth in CEO pay since the mid-1980s can be gauged by looking at historical data. Long time-series data on CEO pay are rare and difficult to collect. The study by Frydman and Saks (2010) is an exception. They analyze long-run trends in U.S. executive compensation using hand-collected panel data from 1936 to 2005. They assembled information for all available years for the largest fifty companies in 1940, 1960, and 1990, a period covering most of the twentieth century. Striking conclusions emerge from the study. First, Frydman and Saks (2010) find the median value of real executive compensation was remarkably flat from around the late 1940s until the mid-1970s. This finding is surprising, and likely different to what many would have conjectured. It suggests the correlation between executive pay and firm growth was actually pretty weak at this time. Second, the authors show that the very large increases in CEO pay, sometimes in excess of 10 percent per annum, occurred since the mid-1970s. Dramatic pay increased occurred from the 1980s onward. Prior to this, modest growth of about 1 percent per annum was the (p. 379) norm. A key takeaway from Frydman and Saks (2010) is that the growth in executive pay is, in the wider historical context, a phenomenon of the past thirty years or so. As such it presents numerous challenges. A convincing explanation of CEO pay needs to explain both the short-run and long-run pattern in CEO pay, as well as the patterns in the cross-section distribution of executive compensation. (p. 380)

Table 13.1. Median CEO Pay, Portfolio Value, and Incentives for the CEOs of U.S. S&P 500 Firms from 1993 to 2008


Total Annual Pay ($millions)

Beginning-of-Year Portfolio Value ($millions)

Beginning-of-Year Incentives “Stock Equivalent Value” ($millions)

Annual Pay/Beginning-of-Year Incentives (%)

All years


























































































Notes: Core and Guay (2010a, p. 7) state: “The data are S&P 500 CEO compensation data from 1993 to 2008. Values are not inflation-adjusted. Total Annual Pay is median CEO salary, bonus, stock and option grants, and other pay for the year shown. Beginning-of-Year Portfolio Value is the median total value of stock plus the value of exercisable and unexercisable options held by the CEO at the beginning of the year shown. To compute the value and incentives of the CEOs' option portfolio, we use the method developed by Core and Guay (2002) with a modification that assumes times-to-exercise equal to 70% of the stated times-to-maturity. Beginning-of-Year Incentives is an estimate of the change in the beginning-of-year value of CEO stock and option holdings for a 100% change in stock price. Annual Pay/Beginning-of-Year Incentives is the median ratio of Annual Pay to Beginning-of-Year Incentives.”

Source: Core and Guay (2010a), table 1, p. 7. Columns 3 to 6 of their paper are extracted and reported here.

CEO Financial Incentives: Paying for Performance

The pay-for-performance issue is central to the economics of executive pay. Critics of compensation arrangements frequently contend that CEO pay is not sufficiently linked to firm performance, implying the interests of executives and shareholders are not well aligned. Jensen and Murphy (1990) lamented this fact. In their influential article they showed that U.S. CEOs were paid like bureaucrats. The problem, they argued, was that executives received most of their compensation in the form of salaries and cash pay, and hardly any in the form of corporate equity, such as stock options and restricted stock. The implication was that executives had few financial incentives to focus on wealth creation, and instead could enjoy the quiet life, or even built leviathan empires since salaries were paid to the size (not performance) of the firm. Since the 1990s, however, the U.S. executive pay landscape has changed radically. CEO pay is inexorably and mechanically linked to stock price performance by the use of options and other share-based payments. As noted, the value of a stock option varies positively with the share price, creating an automatic link between the value to the CEO and share price performance. However, as some commentators strongly argue, the trend to use more options has created its own set of problems, such as encouraging risky and nonoptimal behavior by executives (Bebchuk and Fried, 2004).

It is useful to distinguish between CEO pay and CEO incentives. CEO pay is the amount of remuneration received in a given period of time in exchange for labor services. This includes salaries, bonuses received, the value of option grants, and other share-based compensation granted during the reporting or accounting period. In contrast, CEO financial incentives are driven in large part by the accumulated wealth the CEO has in the firm. The incentives from firm wealth may be defined as the incremental change in total CEO wealth brought about by an incremental change in performance (Murphy, 1999). This captures the link between pay and performance. In consequence, CEO wealth is made up not only of the grants of options this year but also the value of all of the equity-based compensation held by the CEO in the firm, usually accumulated over time (Core and Guay, 2010a; Murphy, 1999).

Pay-for-performance can be calculated in a number of ways. The implicit link between cash compensation and performance may be calculated using regression methods (see Murphy, 1999). More generally, financial economists define it as the change in the value of the CEO's portfolio of assets held in the firm for a given change in performance (Murphy, 1999). Core and Guay (1999) measure incentives as the dollar change in the value of the CEO wealth from a 1 percent change in the stock price. Incentives are the dollar change in executive portfolio wealth arising from a 1 percent increase in shareholder wealth, written as: 1% × (share price) × (the number of shares held) + 1% × (share price) × (option delta) × (the number of options held).7 An alternative measure found in the literature and used by Jensen and Murphy (1990) calculates incentives as the dollar change in CEO wealth from a $1,000 change in firm wealth, summarized as: (fraction of shares held) × $1,000 + (option delta) × (fraction of options held). It varies between $0 (no incentives) to $1,000 (the CEO receives all the increase in generated firm wealth). This measure views incentives as (p. 381) being driven by fractional ownership of the firm. Both measures have appeared in the economics, finance and accounting literature (Conyon and He, 2004; Conyon and Murphy, 2000; Core and Guay, 2010a; Gao, 2010; Murphy, 1999,).

Jensen and Murphy's (1990) original research showed that CEO wealth increased only $3.25 for every $1,000 change in shareholder wealth, suggesting that CEOs had only weak incentives to promote shareholder value. An important reason for the lack of incentives in the original Jensen-Murphy data was the relative low level of equity ownership by CEOs. Hall and Liebman (1998) extended the analysis by Jensen and Murphy, asking whether CEOs were really paid like bureaucrats. Their hand-collected data showed that since about the mid-1980s stock options had become a critical feature of CEO pay. The hypothesis that CEO pay was not linked to performance was overturned. Importantly, they showed a strong positive correlation between CEO compensation and firm performance, arising almost entirely by changes in the value of CEO holdings of stock and stock options. In addition, they demonstrated that both the level of CEO compensation and the sensitivity of compensation to firm performance increased dramatically since 1980, largely because of increases in stock option grants.

Core et al. (2005) also show that CEO pay, the value of equity holdings, and incentives all increased significantly between 1993 and 2003. Importantly, because of the very large holdings of options and stock, CEOs experience significant changes in wealth when the stock price changes. Again, most CEO incentives arise from the portfolio holding of options and stock, not from the correlation between current pay and firm performance. They show that if the stock price declined by 20 percent, then the value of the typical CEO's wealth in the form of stock and options would actually fall by a greater amount than the typical CEO's whole annual pay in that year. Core et al. (2005, p. 1174) conclude: “the assertion that US CEOs receive ‘pay without performance’ is clearly inconsistent with the evidence.”

Recently, Core and Guay (2010a) have examined the provision of CEO incentives within a wealth-based contracting framework. They argue that there are both benefits and costs of imposing performance-based economic incentives on CEOs and senior managers. The implication is that agency problems will arise not only if CEOs have too few incentives but also if they have too many. A central idea in their study is that performance-based incentives should be determined in the context of the CEO's overall personal wealth, including that owned both inside and outside the firm. CEOs with different levels of outside wealth will have potentially very different levels of incentives. Consider the case where a firm requires the CEO to own $10 million of the firm's equity. This will give rise to a different set of incentives for an executive who has $100 million in wealth outside the firm compared to one with $10 million. The implication is that the actual incentives faced by two different executives, each with the same level of equity ownership inside the firm, can be very different depending on their individual levels of outside wealth.8

Core and Guay (2010a) calculate incentives for CEOs from 1993 to 2008. These are reproduced (along with CEO pay figures) in table 13.1. It shows the beginning-of-year market value of the median CEO's stock and option portfolio. In addition, (p. 382) the incentives arising from this portfolio are also given. Core and Guay (2010a) express these incentives as the “stock equivalent value,” using their methodology in Core and Guay (2002) and then converting to stock equivalents. The conversion of options to their stock equivalent is necessary “because $1 of options provides greater incentives to increase stock price than does $1 of stock (options provide more incentives because they are effectively a leveraged position in firm stock)” (Core and Guay, 2010a, p. 6). The ratio of CEO pay to stock equivalent incentives is given in the last column. The following thought experiment helps for understanding the role of incentives. In 2000 the median CEO has incentives of $50.2 million. If the stock price fell by 20 percent, then CEO's incentives would fall by $10.4 million (i.e., minus 20 percent times $50.2). This figure is much greater than the median CEO's total compensation for that year, $6.3 million. Similar effects can be calculated for different years. The final column shows the ratio CEO annual pay to beginning-of-year incentives. It can be interpreted as the necessary negative stock return that reduces CEO beginning-of-year wealth incentive to the same level of annual pay.

Core and Guay (2010a) also find strong evidence that CEO pay is correlated to performance. For 1999 to 2004 they sort the S&P 500 firms into ranked deciles based on the stock return performance of the firms. They find that stock returns in the lowest decile are -44.7 percent and returns in the top decile are 68.8%. As many critics contend, changes in annual CEO pay are only weakly related to stock market performance. In the lowest ranked decile, despite stock returns of -44.7 percent, CEO pay falls by only –13.7 percent. In the top decile, despite returns of 68.8 percent, annual CEO pay increases by 19.7 percent. However, this misses the central point that wealth and equity incentives drive the pay for performance relation. In the bottom decile (firms with stock returns of –44.7 percent), CEOs see losses of $32 million on their beginning-of-year wealth incentives. In the top decile (firms with stock returns of 68.8 percent), CEOs enjoy gains of $31.4 million on their beginning-of-year wealth incentives. The authors conclude that stock price changes can cause large changes in the CEOs portfolio and wealth even though changes in annual compensation might be fairly small.

In addition, Kaplan and Rauh (2010) find strong evidence that wealth and portfolio factors are important in linking CEO pay to performance. For 1999 to 2004 they sort the set of U.S. S&P 1500 firms into five size groups. For each group they sorted CEOs into five subgroups based on how much the CEO had realized in terms of pay and option gains. They then investigated how each of these groups (within each size band) performed relative to the industry over the past three years. They, too, find that actual compensation was highly related to performance. Firms in the top quintile of pay were also in the top quintile of stock performance relative to peers. Firms in the bottom quintile of pay were the worst performance firms relative to the market. They conclude that CEO pay is linked to performance, driven in large part by the use of stock options and equity compensation. (p. 383)

Explaining Executive Pay Outcomes

The empirical evidence suggests that CEO pay has increased significantly, in the United States and elsewhere.9 Not only has the level of compensation increased, the structure of CEO pay has changed, too. Equity compensation, in the form of options and restricted stock, has become much more prevalent. As already noted, significant changes in the pattern of executive pay appeared to happen around the middle of the 1980s. What explains these changes? One reason may have been the increased acceptance by shareholders of equity-based compensation, especially since the publication of Jensen and Murphy's (1990) much cited research on the lack of incentives for U.S. firms. Since then, boards and compensation committees became much more willing to take advantage of option pay that led to large payoffs to executives.

As noted earlier, there are two main theories explaining executive pay. “Optimal contracting” theory explains executive pay as the outcome of market forces and contracting costs. Boards set pay in the context of significant contracting and information costs as well as the market for CEO talent. Pay outcomes, although not always perfect or first-best, are optimal when balanced against information asymmetries and contracting costs (Core and Guay, 2010a; Kaplan, 2008). The second theory is the “managerial power” model. CEOs exercise power and influence over compliant boards and weak owners. They use their power for self-enrichment at the expense of owners, and the resulting pay contracts turn out to be suboptimal. Boards, for various reasons, are unable to resist or are too friendly with the CEO, and in consequence the CEO receives overly generous compensation that is not in the interests of shareholders (Bebchuk and Fried, 2004; Bertrand, 2009).

There is empirical evidence supporting both theories. At present it is too early to conclude that one theory is ultimately correct. The goal of ongoing research, adhering to the scientific method, is to design reproducible experiments or tests that effectively discriminate between competing hypotheses and hence ultimately the broad theories. There are two significant research challenges. First, the data are inherently nonrandom, and double-blind randomized trials are typically not possible. This leads to major difficulties in trying to identify causal effects in pay studies. In consequence, many empirical analyses are observational or correlation studies. Second, it is difficult to design clean tests that effectively differentiate between the optimal contracting and managerial power approaches. For example, empirical evidence that appears to favor one of the theories can be reinterpreted in such a way as to support the other. This can happen due to selection effects or if explanatory variables are endogenous.

CEO Pay and the Board of Directors

Managerial power models of executive pay generally claim that compensation arrangements are too generous (Bebchuk and Fried, 2004). CEO power leads to levels of pay above the arm's-length negotiated optimal contracting level. Corporate (p. 384) boards are relatively weak compared to the CEO. Executive pay does not increase indefinitely because of “outrage” costs or other binding constraints. However, CEO power and influence is sufficiently widespread that deviation from market forces and optimal contracting are common. There are many potential tests of the managerial power hypothesis, and a challenge for research is to design tests that rule out the competing efficiency (optimal contracting) explanation.

One test of the managerial power hypothesis is that weak boards lead to high CEO pay (Bebchuk and Weisbach, 2010). What constitutes a weak board? The literature typically designates a board as poorly constituted if it is too large, and therefore it is difficult for directors to oppose the CEO, or if the CEO has appointed the outside directors, who are beholden to the CEO for their jobs. In addition, boards may be called weak when directors serve on too many other boards, making them too busy to be effective monitors; or if the CEO is also chair of the board, since conflicts of interest arise. Alternatively, the board may be too friendly with the CEO, coming from the same social or friendship groups, and therefore pay insufficient attention to their fiduciary duties to shareholders. When boardroom governance is poor, excess pay as an agency cost is expected. Empirical evidence using cross-section data often support the claim that agency costs are greater when boards are poorly constituted. The evidence shows that in a cross-section, poorly designed board structures are associated with greater excess pay (Core et al., 1999).

However, there is an important challenge to the hypotheses that weak boards lead to excess pay: the time-series data do not fully support it. Boards have become much more independent over time, measured by the absence of affiliated directors at the same time pay has increased. An affiliated director is a person who is an employee of the company or in some other material way is linked or affiliated to the firm. The most prevalent reasons are providing professional services or being a recent former employee. The fraction of affiliated directors on company boards has been declining over time—the implication being that the quality of board governance has increased. The time-series data, then, are at odds with managerial power (rent-extraction) hypothesis. It predicts as governance quality goes up CEO pay should go down. However, CEO pay and board quality have both increased over time in the United States. This suggests one should look elsewhere for the growth in CEO pay in the United States.

An essential feature of the executive pay-setting process is the compensation committee (Baker et al., 1988). Ineffective pay committees give the CEO an opportunity to promote his interests at the expense of shareholder welfare. Studies find little evidence that compensation committees are ineffective. Conyon and Peck (1998) investigate the relation between board control, the compensation committee, and executive pay, using panel data on the 100 largest U.K. firms between 1991 and 1994. The quality of governance increases over time. In 1991, 78 percent of firms have a compensation committee, increasing to 99 percent in 1994. The proportion of independent directors on the committee increases from 87 percent in 1991 to 91 percent in 1994. The study shows that CEO pay is greater in firms with compensation committees or those with a greater fraction of outsiders on the committee. (p. 385) However, they find the link between pay and performance is greater in firms with a greater proportion of outside directors on the compensation committee. Daily et al. (1998) study 200 Fortune 500 companies in 1992. They find no relationship between CEO pay and the proportion of affiliated directors on the compensation committee. Other studies from the United States and the United Kingdom have also failed to find that compensation committees result in excess CEO pay or poorly designed compensation contracts (Anderson and Bizjac, 2003; Bender, 2003; Conyon and He, 2004; Gregory-Smith, 2009).

Compensation Consultants and CEO Pay

Compensation consultants are firms or individuals who advise the board of directors about executive pay practices. Critics contend that consultants lead to excessive CEO pay and poorly designed contracts (Bebchuk and Fried, 2004; Waxman, 2007).10 They argue that consultants are not sufficiently independent and suffer from conflicts of interest because they sell other services to their clients and are thus wary of provoking the CEO for fear of jeopardizing this other business. An alternative (optimal contracting) perspective is that compensation consultants are experts who provide valuable information and data to busy boards of directors. Their presence ameliorates opportunistic behavior by CEOs and leads to well-structured optimal compensation contracts. Do pay consultants promote the best interests of the firm's owners, or do they simply enrich entrenched CEOs?

The available empirical evidence shows that consultants have only a limited effect on CEO pay and incentives. Consultants do not appear to be the primary driver of the recent growth in executive pay. Murphy and Sandino (2010) find evidence in both the United States and Canada that CEO pay is greater in companies where the consultant provides other services. In addition, they find that pay is higher in Canadian firms when the fees paid to consultants for other services are large relative to the fees for executive compensation services. This evidence suggests that greater agency costs lead to higher compensation. However, they unexpectedly find that CEO pay is higher in U.S. firms where the consultant works for the independent board rather than for management. In another study, Cadman, Carter, and Hillegeist (2010) investigate compensation consultants' potential cross-selling incentives using 755 firms from the S&P 1500 for 2006. Conditional on the firm retaining a consultant, Cadman et al. (2010, p. 263) are “unable to find widespread evidence of higher levels of pay or lower pay-performance sensitivities for clients of consultants with potentially greater conflicts of interest.” They conclude there is little evidence that potential conflicts of interest between the firm and its consultant are a primary driver of excessive CEO pay. Conyon, Peck, and Sadler (2009) also perform a comparative study of the relation between CEO pay and consultants using British and American data for 2006. They find that CEO pay is generally greater in firms that use compensation consultants, which is consistent with the managerial power theory of executive pay. They also show that the amount of equity used in the CEO compensation package, such as stock options, is greater in firms that use (p. 386) consultants. This is consistent with alignment of manager and shareholder interests and the optimal contracting theory of pay. Finally, there is little evidence that using consultants with potential conflicts of interest, such as supplying other business to client firms, leads to greater CEO pay or the adverse design of pay contracts. The evidence is consistent with Cadman et al. (2010).

Option Plans and Relative Performance

Another proposed test of the managerial power hypothesis is the lack of relative performance in U.S. CEO compensation contracts. Stock option contracts reward CEOs based on absolute, not relative performance. Simple agency models predict that the market component of firm performance should be removed from the CEO's compensation package because the CEO's actions do not influence the market, incentives are not improved, and the pay contract is riskier. By indexing stock options to the market, contract efficiency is improved—and only rewards the CEO for outperforming peers. Bebchuk and Fried (2004) argue that because option contracts lack explicit relative performance conditions, executives enjoy windfall gains as market value increases. In short, CEOs are rewarded for “luck,” not their performance or skill. The typical U.S. stock option plan does not explicitly filter out general stock price increases that are attributable to market or industry trends and are therefore unconnected to the executive's own performance. This means that in rising markets, the value of a CEO's options increases even if firm performance is worse than the market.

Using indexed options would be one way to explicitly introduce relative performance evaluation into the pay contract and provide incentives at lower cost. However, the nearly universal use of fixed price options, where the option exercise price is usually set equal to the stock price at grant, does not necessarily reflect managerial power. First, U.S. accounting treatment of options in the 1990s meant that indexed options would attract an accounting charge and need to be expensed. Thus, faced with a decision to use an indexed option that would increase firm costs versus using a standard fixed price option, which attracts no charge, firms choose the latter. This choice is not necessarily because of managerial power but because of an accounting anomaly. The perceived cost to the board made options seem lower than their economic cost (Murphy, 2002).

Bebchuk and Fried (2004) argued the accounting explanation for lack of relative performance (or reduced-windfall options) is incomplete, because, among other reasons, management lobbied against expensing options and did not exert effort to get nonexpensing for indexed options. Second, in the United Kingdom, stock options and other long-term equity incentive plans generally have performance triggers. These performance measures are growth in earnings per share, or stock returns relative to a market index. Of course, one might question if the performance measures are sufficiently demanding, and so on, for CEOs. However, the differences between the United Kingdom and the United States suggest that regulatory differences might be an important explanation for the different styles of equity pay. (p. 387)

Not only is explicit market indexing in compensation contracts rare in the United States, studies also find that there is little evidence of relative performance evaluation in the estimated relationship between pay and performance (Gibbons and Murphy, 1990). A test of relative performance in CEO contracts is a negative correlation between CEO pay at a focal firm and industry performance, after controlling for firm performance. The data do not generally support this hypothesis. The lack of a negative correlation between CEO pay and market performance, however, may not necessarily imply managerial power. For instance, more complicated agency models suggest the value of a CEO's human capital changes with market fortunes. If so, CEO compensation also moves in the same direction as the market.

CEO Perks

In addition to salaries, restricted stock, stock options, and so on, executives also receive benefits in the form of perks. These can include the use of corporate aircraft, country clubs, and financial planning advice from the firm. Boards are therefore responsible for setting perks and pensions—as well as the level of cash pay, stock options, and other equity pay. Although compensation in publicly trade firms is now highly visible, critics contend that “backdoor pay” or “stealth pay” in the form of perks and pensions are prevalent. More recently changes in disclosure rules in the United States and the United Kingdom mean that investors can observe deferred payments in more detail than was previously the case. A central question is whether such payments represent compensation by the back door, or whether they form part of an optimal compensation strategy that aligns the interests of managers to owners.

Rajan and Wulf (2006) investigated whether perks represent managerial excess. They use proprietary data on a number of company perks. They conclude that firms offer perks in situations where they are most likely to facilitate managerial productivity. That is, perks are used to enhance owner welfare. In consequence, the authors conclude that perks do not represent managerial excess, but instead form part of the complex contracting between the CEO and the board. In contrast, Yermack (2006) investigated CEO use of corporate jets disclosed by firms in their annual reports. His main finding is that when the use of aircraft is disclosed publicly to shareholders, there is a drop in stock price of about 1 percent. The negative impact on asset values implies that executive perks destroy firm value. Interestingly, Yermack (2006) does not find that the perk consumption is related to CEO ownership stake in the firm or CEO salaries. The optimal provision of pension and perquisite arrangements in firms promises to be an important topic for future research.

Market-Based Explanations

One important explanation for changes in executive compensation is the shifts in the demand and supply for managerial talent. As in all labor markets, for a given supply of talent, an increase in the demand for skilled CEOs increases CEO (p. 388) compensation. Himmelberg and Hubbard (2000) argue that the supply of highly skilled CEOs who are capable of running large, complex firms is relatively inelastic. Economic shocks to aggregate demand increase both the value of the firm as well as the marginal value of the CEO's labor services to the firm. They show that in equilibrium, such shocks lead to greater executive compensation. Some argue that the labor market for executives is in reality thinly traded, and that CEOs of firms all know one another or sit on each other's boards. This is a fruitful line for future research. However, it might be noted that the available number of CEO job positions at leading companies seems far fewer than the number of individuals who aspire to occupy those posts.11

Gabaix and Landier (2008) build an economic model of CEO pay determination. CEOs have different talents and are then competitively matched to firms. In equilibrium, the model predicts that CEO pay is determined by the size of the firm. The theoretical model explains the level of CEO pay across firms and over time. Dispersion in CEO talent can lead to large differences in compensation outcomes. The model is tested using U.S. data. They show that firm size has increased significantly in recent decades and conclude that the “size of large firms explains many of the patterns in CEO pay, across firms, over time, and between countries.” They find that the sixfold increase of U.S. CEO pay between 1980 and 2003 can be fully attributed to the sixfold increase in market capitalization of large companies during that period. In consequence, their model and empirical evidence points to economic and market factors driving CEO pay, rather than the rent-seeking power of CEOs.

Murphy and Zábojnik (2004) explain CEO pay based on changes in the relative importance of general and specific managerial capital. General managerial capital (such as knowledge of finance, accounting, or management of human capital) is valuable and transferable across companies, whereas specific managerial capital skills (such as knowledge of firm suppliers or clients, etc.) are only valuable within the organization. The firm decides whether to fill a CEO vacancy by choosing an incumbent or external candidate. A firm that hires outside managers forgoes a CEO with valuable firm-specific skills. However, it selects from a larger pool of managers, allowing better matching of managers to firms. Firms will increasingly appoint external CEO candidates as general managerial capital becomes increasingly valuable relative to firm-specific managerial capital. Labor market competition for talent, especially for CEOs with general transferable skills, then determines CEO pay. Murphy and Zábojnik (2004) argue that general managerial skills have become more important in the modern firm, driving up pay. Empirically, they show external CEO hires as a percentage of all CEO appointments increased from 15 percent in the 1970s to 27 percent during the 1990s. In addition, external appointments to the CEO position receive a compensation premium—and this premium has increased during the 1990s.

Kaplan and Rauh (2010) also ague that market forces are primarily responsible for changes in executive compensation arrangements. Such pressures determine not only CEO pay but also the compensation received by other talented individuals in society. They compare the pay of CEO at publicly traded U.S. firms to other (p. 389) similarly well-qualified individuals. If people in the “control group” have done as well as the “treatment” group of publicly traded firms, then by this test CEO pay is not excessive. Kaplan and Rauh (2010) conclude that the pay of talented groups such as hedge fund mangers have done better than CEOs at publicly traded firms. Kaplan (2008, p. 12) similarly remarks: “while CEOs earn a great deal, they are not unique. Other groups with similar backgrounds and talents— particularly hedge fund, venture capital, and private equity investors; investment bankers; and lawyers have done at least as well over the last 10 or 15 years. The increase in pay at the top appears to be systemic.”

Conyon, Core, and Guay (2011) provide a market-based explanation for changes in CEO pay. They contrast the United States to the United Kingdom to test the excess pay hypothesis. They choose the United Kingdom because it shares common governance and capital market features with the United States but (at least until recently) has been less prone to claims that executive pay is excessive. The authors find that median U.S. CEO pay in 2003, defined as the sum of salary, bonus, grant date value of restricted stock and options, and benefits and other compensation, is approximately 40 percent greater than for U.K. CEOs. However, they argue that CEOs who hold greater risky pay in the form of equity are likely to demand a risk premium in the form of greater pay. They demonstrate that U.S. CEOs bear substantially greater equity risk than U.K. CEOs. Their findings bear out evidence contained in Conyon and Murphy (2000). In addition, Conyon et al. (2011) make risk adjustments to observed total pay, based on assumptions about CEO risk aversion and outside wealth owned, to reflect the differences in equity incentives held by CEOs in the two countries. They then document that there is little evidence that U.S. CEOs' risk-adjusted pay is significantly greater than that of U.K. CEOs. In a related study, Fernandes et al. (2009) also find that the U.S. CEO pay premium falls significantly if one controls for relative risk aversion. Their analysis is based on compensation practices in fourteen countries where there is sufficient mandated pay disclosure. Overall, they conclude that a large part of the observed U.S. pay premium reflects compensating differentials for the higher risk of U.S. pay packages.

Executive Compensation and the Financial Crisis

The catastrophic meltdown of capital markets in 2008, and the economic global recession that followed, fueled intense debate about the role of executive compensation at major financial institutions.12 The compensation arrangements at banks were blamed for igniting the worst economic downturn since the Great Depression of the 1930s. Critics of CEO pay asserted that compensation arrangements at many financial institutions encouraged individuals to take actions that were too risky, or (p. 390) worse, that bankers were effectively rewarded for the failure of their firms (Bebchuk and Spamann, 2010). Others argue that pay practices in the financial sector were not a major contributing factor to the financial and economic crisis.

Since the 2008 financial crisis there has been major corporate governance legislation in the form of the Dodd-Frank Act (2010). The Dodd-Frank Act significantly increases transparency in relation to executive compensation in the United States and requires further accountability via a regular shareholder vote on executive compensation. In addition, a blue-ribbon commission, the Financial Crisis Inquiry Commission ( investigated the causes of the financial and economic crisis. It attributed part of the blame for the crisis to compensation practices at financial institutions, which encouraged inappropriate risk taking. At the time of this writing, the precise causes of the financial crises remain a hotly debated issue. The role played by compensation contracts during the financial crisis, especially incentive arrangements at leading banks, remains a topic for continued research. A discussion of the issues, and emerging empirical evidence, is provided in Conyon et al. (2010).13

Outrage over Executive Compensation and the Financial Crisis

Public outrage at executive pay increased from 2008 in the wake of the financial crisis. There are at least three reasons for this. First, bankers received lavish bonuses at around the same time their firms required substantial government bailouts. Second, there was a suspicion that compensation systems in place at banks, together with bank corporate culture, created perverse incentives for excessive risk taking that led to the financial crisis. Third, there was outrage at the way the financial crisis detrimentally affected those on Main Street compared to Wall Street. Rising unemployment, falling wages, and deteriorating output on Main Street immediately followed from the 2008 macroeconomic shock. But for many observers it seemed that bankers on Wall Street were immune to the harsh new economic realities. Ailing banks continued in business, aided by government and taxpayer funding, because they were deemed “too big to fail.” The continued high levels of CEO pay made it seem as if it was just business as usual.

The history of compensation at financial institutions during the financial crisis is yet to be written, but firms such as Merrill Lynch and AIG will figure prominently. These two institutions triggered considerable outrage over banker pay. In December 2009, just before the completion of the merger with Bank of America, Merrill Lynch distributed about $3.6 billion in bonuses to its 36,000 employees. The top 4 employees received a combined total of $121 million; the top 14 individuals received a combined total $249 million, and the top 140 received a collective amount of $858 million (Cuomo, 2009). The use of taxpayer bailout money from the federal Troubled Assets Relief Program (TARP) to rescue the banks caused immense public outrage and scandal. Likewise, controversy and outrage was fuelled from the (p. 391) AIG bonus payments. AIG disclosed it was allocating approximately $218 million in bonus payments to employees of its financial services division. It had received colossal amounts of bailout money ($170 billion) and had posted massive financial losses ($61.7 billion). In addition, further payments to AIG employees were widely anticipated.

The public's outrage spurred regulators' appetites to rein in executive compensation via legislation. Conyon et al. (2010) document that seven bills were introduced in the House of Representatives and Senate aimed specifically at bonuses paid by AIG and other bailed-out firms using TARP funds. Government action and the regulation of bank pay also appeared as a favorable option among the general public. An Economist newspaper/YouGov poll in 2009 asked: “Are you in favor of allowing the government to set the salaries of top executives at banks and financial institutions that receive assistance from the federal government?” It found 57.8 percent favored intervention and only 23.5 percent opposed such measures; the remainder were unsure.14 Further evidence of public and policy maker outrage over lavish compensation arrangements (especially at banks) from about 2008 onward can be easily found in mainstream media outlets.

Bank Executive Compensation and Performance

Compensation patterns at banks are undoubtedly controversial. Untangling the relation between bank pay, firm performance, and the financial crisis is difficult—and it is especially challenging to identify causal effects. Pay is high in banks and the crisis had something to do with banks, but these facts do not imply that bank pay caused the financial crisis. To what extent was CEO pay and other compensation arrangements at financial institutions a contributory factor in the 2008 financial crisis? Were CEOs unduly rewarded as their firms failed?

The claim that CEO pay was instrumental in triggering a financial crisis can be framed in a number of ways (Bebchuk and Spamann, 2010; Fahlenbrach and Stulz, 2011). One hypothesis is that CEOs focus excessively on the short-term rather than long-term organizational performance. Another is that stock options and other forms of equity pay promoted excessive risk taking, inconsistent with shareholder interests. Another theme is that the capital structure at banks contained too much financial leverage, encouraging conflicts between debt- and equity-holders and promoting excessive risk taking. Ultimately, the relation between pay arrangements at banks and other financial institutions and the depth of the financial crisis are a matter for empirical scrutiny and evidence. A few nascent studies have begun this task by comparing bank to nonbank pay structures and by analyzing compensation contracts before, during, and since the financial collapse of 2008. It is important to emphasize that the evidence is only beginning to emerge, so any conclusions at this stage must remain tentative.

Bebchuk and Spamann (2010) argue that executive compensation arrangements at banks are poorly designed and contend that the regulation of banks' executive pay should be a central feature of future financial regulation. Moreover, (p. 392) they assert that this approach can complement and strengthen traditional types of financial regulation. Their main argument is that the capital structure at banks leads to economic distortions and risky behavior by executives: “Equity-based awards, coupled with the capital structure of banks, tie executives' compensation to a highly levered bet on the value of banks' assets. Because bank executives expect to share in any gains that might flow to common shareholders, but are insulated from losses that the realization of risks could impose on preferred shareholders, bondholders, depositors, and taxpayers, executives have incentives to give insufficient weight to the downside of risky strategies” (Bebchuk and Spamann, 2010, p. 1). They claim that evidence from the extant economics and finance literature supports their arguments. However, other emerging research has so far been unable to show a robust causal link between the structure of bank executive compensation and the financial crisis.

Cai, Cherny, and Milbourn (2010) study risk-taking incentives in executive compensation contracts and compare banks to nonbanks. They argue that standard agency model give rise to a conflict of interest between debt- and equity-holders. Contracts are designed to be optimal from the shareholders' point of view and focus managers' attention stock prices and earnings by using stock options, restricted stock, earnings bonuses, and so on. Managers may take actions that are good for shareholders, but not necessarily so for debtholders such as banks, bondholders, and depositors. They argue there is more reliance on debt and leverage in banking and so a greater bias toward excessive risk taking. They conclude that the standard executive pay structure “in banking and finance before the financial crisis reveals some potentially problematic practices.” These practices may have encouraged “short-termism” and “excessive risk taking.” The theoretical arguments are analogous to the Jensen and Meckling (1976) agency cost of debt problem. Although conceptually plausible, it is also important to address why the debt-versus-equity issue became more problematic around 2007, as opposed to some other time.

In a recent study Bhagat and Bolton (2011) analyzed executive pay arrangements in the fourteen largest U.S. financial institutions from 2000 to 2008. They focused on the buy and sell decisions of executives of their own bank's shares. Their empirical analysis finds that CEOs are about thirty times more likely to be involved in a sell transaction compared to a buy transaction. They suggest that CEOs believed their stock was over- rather than undervalued—and this may have lead to excessive risk taking. Recently, Bell and Reenen (2010) documented the relation between bankers' pay and income inequality in the United Kingdom. They show that observed increases in U.K. wage inequality is correlated to the increases in bank bonuses.

Fahlenbrach and Stulz (2011) investigate a sample of ninety-five U.S. banks in 2006 and follow them through to December 2008. Of the original ninety-five institutions in 2006, seventy-seven remain in the sample; twelve merged and eight were delisted. The authors perform numerous tests and ultimately reject the hypothesis that compensation arrangements at U.S. banks were fundamentally flawed. They find evidence of a negative relation between measures of CEO incentives at the (p. 393) end of 2006 and long-term performance of banks, measured as the buy-and-hold returns between July 2007 and December 2008.15 Their evidence shows that CEOs with incentives that are better aligned to shareholders actually performed worse in the crisis. Similarly, Cheng, Hong, and Scheinkman (2009) find that executives with better incentives have higher CAPM betas, have higher return volatilities, and are more likely to be in the tails of performance, with high precrisis performance and low performance during the crash. In Europe, Bechmann and Raaballe (2009) analyzed CEO pay and performance in a sample of Danish banks. They find that CEOs with more incentive-based compensation, and therefore much more to lose from poor performance, fared significantly worse than other banks during the crisis. This evidence, then, points to a negative correlation between incentive compensation structures and performance during the crisis: banks that performed worst in the crisis are those with better ex ante executive financial incentives.

Fahlenbrach and Stulz (2011) interpret their results as meaning that CEOs took decisions they felt would be profitable for shareholders ex ante, but ultimately these turned out to perform badly ex post. To support this conjecture, they argue that if CEOs had advance knowledge that their decisions were not in the best interests of shareholders, then they would have taken actions to insulate their personal wealth from adverse stock price movements. For example, they would have sold their shares or engaged in other hedging activities. However, the authors find no evidence of unusual share selling or other hedging activity by bank executives in advance of the crisis. Furthermore, the value of the median CEO's 2006 aggregate stock and option holdings is significant: more than eight times the value of his 2006 total compensation. CEO ownership, in the form of shares and vested unexercised options, is very important in banks. Modest declines in asset values can easily outweigh the CEO's annual pay. The amount of CEO wealth at risk prior to the financial crisis makes it seem less likely that rational CEOs knew of an impending financial crash or knowingly engaged in too-risky behavior. To do so would put in jeopardy considerable personal wealth.16 In the authors' study, on average, CEOs in their sample lost $30 million in stock and option value, and the median CEO lost over $5 million. Ultimately, Fahlenbrach and Stulz (2011) reject the claim that bank CEOs were to blame for the crisis. Adams (2009) compared financial and nonfinancial firms from 1996 to 2007. She found that corporate governance arrangements in financial firms are on average no worse compared to nonfinancial firms. Controlling for the size of the firm, she documents that both the level of CEO pay and the fraction of equity-based CEO pay is actually lower in banks, even in 2007 at the start of the crisis. Also, she documents that banks receiving bailout money had more independent boards of directors compared to nonbailout banks. In addition, Adams (2010) cautions that employing the same governance standards advanced in nonfinancial firms to banks is unlikely to improve the governance of banks.

Murphy (2009) also examined CEO pay in U.S. financial institutions during the recent crisis. He also documents that bank CEO pay and wealth are adversely affected as the crisis unfolds, especially relative to other firms. He studies (p. 394) thirty-six companies receiving TARP funding from the U.S. government. He finds that average CEO bonuses fell significantly by 84.3 percent from over $2.3 million in 2007 to only $363,082 in 2008 for banks in receipt of TARP funds. In contrast, CEO bonuses in twenty-three financial services firms not receiving TARP funds fell by only 13 percent. CEO bonuses fell even less in a control group of nonfinancial firms. The evidence shows that the financial shock of 2008 had a large negative impact on the compensation received by CEOs. In addition, wealth from holding stock and options in their firms fell dramatically for CEOs of financial firms receiving TARP funds. Murphy (2009) finds that the average intrinsic value of in the money options fell by about 95 percent from $8,694,980 in 2007 to $428,880 in 2008 for CEOs of firms receiving TARP funds. In contrast, the intrinsic value of options decline by about 65 percent for CEOs of non-TARP financial firms, from $21,909,390 to $7,550,710. A similar pattern emerges for restricted stock. The value of restricted stock for CEOs of firms in receipt of TARP funds falls by about 80 percent between 2007 and 2008, whereas the value of restricted stock in firms not in receipt of TARP funds falls by about 43 percent. Murphy (2009, p. 6) concludes: “Given the penalties for poor performance inherent in both cash and equity incentive plans, there is nothing inherent in the current structure of compensation in financial service firms that lead to obvious incentives to take excessive risks.” Core and Guay (2010b) also conduct a comparative analysis of CEO pay and incentives in the financial services industry relative to a matched sample of nonfinancial firms over the period 1993 to 2008. They find that trends in median total CEO pay for banks and nonfinancial firms are fairly highly correlated and find few persistent differences in CEO pay levels across the two groups of firms. Indeed, comparing the wealth incentives between banks and nonbanks, they find evidence that points to the bank sector having fewer performance and risk-taking incentives compared to nonbanks. Erkens, Hung, and Matos (2010) investigate the relation between corporate governance and firm performance from 2007 to 2008 using data on 296 financial firms from 30 countries. They found that firms with more independent boards and higher institutional ownership had worse stock returns during the crisis, attributed to the fact that firms with higher institutional ownership took more precrisis risk, leading to larger shareholder losses. In addition, the firms with more independent boards raised more equity capital during the crisis. This led to a wealth transfer from existing shareholders to debtholders. The authors conclude that their “findings cast doubt on whether regulatory changes that increase shareholder activism and monitoring by outside directors will be effective in reducing the consequences of future economic crises.”

Conyon et al. (2010) provide further evidence on bank compensation, this time investigating both the United States and Europe for 2006 and 2008. Table 13.2 is based on their report. In Europe they find that median CEO bonuses declined by about 84 percent in banks compared to about 6 percent in nonbanks, between 2006 and 2008. In the United States, median CEO bonuses fell by about 97 percent in banks and only about 26 percent in nonbanks.17 A similar pattern emerges for CEO wealth between 2006 and 2008. In Europe, median CEO wealth declined (p. 395) by about 46 percent in banks compared to about 43 percent in nonbanks. In the United States, CEO wealth fell by about 75 percent in banks and approximately 55 percent in nonbanks. Conyon et al. (2010, p. 110) remark: “Overall, the results for both European and American banking CEOs are inconsistent with the idea that banking executives faced rewards for success but no real penalties for failure.” The evidence is consistent with the hypothesis that bank CEOs with better ex ante incentives, namely, those aligning their interests with shareholders, faced significant penalties for poor performance, ex post.

Table 13.2. Comparison of 2006 and 2008 Bonuses and Year-End Wealth for CEOs of Banking and Nonbanking Firms.


United States





Median bonuses (€ooos)

Number of CEOs
























Median wealth (€ooos)

Number of CEOs
























Notes: Derived from Conyon et al. (2010), table 4.4. CEO Wealth is the fiscal year-end value of the CEO's stock and restricted stock, plus the year-end intrinsic value of stock options. Data described in Conyon et al. (2010). The European data are from BoardEx and the U.S. data (including Black-Scholes values) are calculated based on year-end option holdings. “Bonuses include payouts from both annual and longer-term (non-equity-based) incentive plans. Monetary amounts are in 2008-constant Euros; US dollar-denominated data are converted to Euros using the 2008 year-end exchange rate (€1 = $1.3919).” Conyon et al. (2010).

The current empirical evidence suggests that compensation and incentives do not appear especially unusual in banks and financial institutions compared to nonbanks. Indeed, CEOs of banks suffered significant negative wealth effects following the financial crisis, along with executives at nonfinancial institutions. In addition, the current evidence suggests that incentive structures at banks did not lead to excessive risk taking by CEOs. If bank CEO incentives did not cause the financial crisis, what did? Conyon et al. (2010) speculate on myriad other potential candidate explanations including “social policies on home ownership, loose (p. 396) monetary policies, ‘Too Big to Fail’ guarantees, and poorly implemented financial innovations such as exotic mortgages, securitization, and collateralized debt obligations.” Allen, Babus, and Carletti (2009) review the financial crisis, providing both theory and evidence. Incentive compensation as a cause of crises is conspicuously absent from their review. The authors state: “The first explanation of banking crises is that they are a panic. The second is that they are part of the business cycle.” In addition, the financial crisis was characterized by severe liquidity problems in interbank markets and problems of contagion. Undoubtedly, the causes of the crises will be debated for years to come.

The Financial Crisis Inquiry Commission, 2011

The scale of the financial crisis prompted official enquiries into its causes and consequence. The remit of the U.S. Financial Crisis Inquiry Commission (FCIC, 2011) was to “examine the causes of the current financial and economic crisis in the United States” (FCIC, 2011, p. xi). The commission concluded that the “financial crisis was avoidable,” noting that the crisis was promulgated by the actions, inactions, and mistakes of individuals in the financial system that failed to properly manage risk. The report is over 600 pages long, and contains 22 chapters and supporting material. There were ten members of the commission. It is noteworthy that six voted to accept the commission's report and four members dissented. The disagreement was serious enough for dissenting statements and reports to be issued. This suggests that it is very difficult to obtain unanimous or even consensus agreement about the primary causes of the crisis.

In the area of corporate governance, the FCIC asserted that “dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis.” The commission was critical of the compensation practices, asserting that these led to perverse incentives and excessively risky behavior:

The Compensation systems—designed in an environment of cheap money, intense competition, and light regulation—too often rewarded the quick deal, the short-term gain—without proper consideration of long-term consequences. Often, those systems encouraged the big bet—where the payoff on the upside could be huge and the downside limited. This was the case up and down the line—from the corporate boardroom to the mortgage broker on the street. (FCIC, 2011, p. xix)

The commission's conclusions were based largely on observing the levels and properties of the compensation systems in place at many financial institutions, along with interviews with key individuals. First, the commission documented that compensation in financial institutions began to outstrip pay in nonfinancial institutions from about 1980 onward, and the gap between them steadily increased up to 2008. As noted, Cai et al. (2010) also document that executive pay in the financial sector was greater than in nonfinancials, and the equity pay (such as options) was more prevalent. Second, the commission was (p. 397) critical of stock options and other performance-based compensation systems: “Stock options had potentially unlimited upside, while the downside was simply to receive nothing if the stock didn't rise to the predetermined price.” Other pay mechanisms, such as tying compensation to earnings also provided (unintended) incentives for executives to focus on the short term. The commission says that these pay structures created incentives to increase risk and leverage to achieve higher returns and profits. However, the report asserts that problems with such pay structures were systemic and those involved were unable to change the underlying reward model. The commission's report cites Sandy Weill, former Citigroup CEO, as saying “I think if you look at the results of what happened on Wall Street, it became ‘Well, this one's doing it, so how can I not do it, if I don't do it, then the people are going to leave my place and go some place else.’ ” Risk management “became less of an important function in a broad base of companies, I would guess” (FCIC, 2011, pp. 63–64).

The FCIC is wide-ranging and documents many potential causes. Accordingly, it is difficult to apportion precisely how much weight to give the problems caused by executive and banker compensation in contributing to the crisis. Moreover, in dissenting statements, four of the ten commissioners disagreed with significant aspects of the commission's analysis. Hennessey, Holtz-Eakin, and Thomas (2011, pp. 413–439) ascribed the major causes of the crisis to ten separate factors. These include a credit bubble, a housing bubble, nontraditional mortgages, credit rating and securitization, financial institutions correlated risk, leverage and liquidity risk, risks of contagion, common macroeconomic shocks, a severe financial shock, and the financial shock causing an associated economic crisis in the real economy. These authors do not see compensation arrangements as a prime cause of the crisis.

Dodd-Frank Act, 2010

In the wake of the financial crisis, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act, also known as the Dodd-Frank Act, on July 21, 2010.18 The act extends regulation in the financial and nonfinancial sectors. It has important sections relating to corporate governance, accountability, and executive compensation (Title IX, Subtitle E). The act is very detailed and runs over 800 pages.

The Dodd-Frank Act requires a regular shareholder vote on executive compensation at least once every three years (Section 951). The goal is to make executive compensation practices more accountable to shareholders. The Dodd-Frank Act requires enhanced transparency. Compensation committees must be independent, and the act outlines rules relating to the governance of external advisers, such as compensation consultants. Section 952 requires the members of the compensation committee to be independent, which takes into account factors such as the source of compensation received by the member of the board of directors, including any consulting, advisory, or other compensatory fee paid to the member (p. 398) of the board of directors. In addition, independence is assessed by whether a member of the board of directors is affiliated with the issuer, a subsidiary, or an affiliate of a subsidiary of the issuer. The goal is to improve the context of executive pay setting.

Section 953 of Dodd-Frank deals with enhanced compensation disclosure. The following new information is required to be disclosed by firms. First is the median of the annual total compensation of all employees of the firm, except the CEO. Second is the annual total compensation of the CEO, and third is the ratio of the amount employee compensation to the amount received by the CEO. These new information disclosure rules will give shareholders, investors, and policy makers more information about the distribution of pay within the firm. In addition, Dodd-Frank makes provision for the recovery of erroneously awarded compensation (Section 954), more disclosure regarding any employee or director hedging activity (Section 954), and enhanced compensation structure reporting (Section 956). This includes prohibiting incentive pay arrangements that encourage inappropriate risk taking by covered financial institutions. In summary, the Dodd-Frank Act significantly upgrades disclosure on executive compensation and empowers shareholders.


Executive compensation is a controversial subject attracting significant attention from the media, policy makers, and academics. For many years, commentators have highlighted the high levels of pay, asking whether CEOs were paid too much. There are two, essentially competing views about CEO pay. The managerial power view contends that CEOs are able to set their own pay in ways that lead to significant deviations from what is optimal from shareholder and society welfare. The alternative optimal contracting theory argues that CEO pay arrangements, though not always perfect, are determined by market forces. Pay is the outcome of the costs and benefits of contracting and arm's-length bargaining between boards and CEOs.

This chapter reviewed some contemporary themes in the economics of executive compensation. I considered the evolution of executive pay—CEO pay is made up of salaries, bonuses, stock options, restricted stock, and other benefits, such as pensions and perks. CEO pay has increased significantly over the past thirty or so years. The increase in pay from the 1980s onward in the United States was largely driven by the increased use of stock options. During this time, compensation contracts morphed and CEOs began holding more of their firm's common equity, or call options, on those securities. The level of pay is not the only factor to consider: the structure of compensation matters, too. Since the mid-1980s equity compensation became an increasingly important factor in CEO (p. 399) compensation contracts, leading to much more significant pay for performance. Historically, the issue for investors was the lack of pay-for-performance in executive pay contracts. The classic academic statement of this is Jensen and Murphy's (1990) study showing how little CEO pay varied with firm performance (value) in the United States. The use of stock options and other equity pay plans rectified this state of affairs.

Another section summarized some of the (many) reasons for the changes in CEO compensation. These included managerial power explanations and optimal contracting or market-based explanations. Attention was given to the importance of the pay-setting process, including the board of directors, compensation committees, and compensation consultants.

Set against the recent financial crisis, I consider the governance of executive pay at banks. The causes of the financial and economic crisis are many. Several commentators pointed to executive compensation contracts as the source of excessive risk taking. The nascent empirical evidence for this conjecture is mixed, and other causes centering on housing bubbles, monetary policy, credit policies, and financial market contagion are also important to consider.

Undoubtedly, the issue of executive compensation will remain at the forefront of corporate governance debates for the foreseeable future. The recent financial crisis has reignited interest in executive pay regulation, enhanced disclosure rules, and legislation on a scale not anticipated only a few years ago. The issue of executive pay is also likely to become more global. Criticism of executive pay in several European counties has increased, and proposals for legislation and regulation of CEO pay are openly advocated. Future research designed to provide a better understanding the operation of executive labor market, and especially how CEO compensation allocates scarce talent, is critical.


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                                                                                                                  (1.) The Economist magazine sponsored a debate with the following proposition: “This house believes that on the whole, senior executives are worth what they are paid.” The result was that 78 percent were against the motion. (October 2009). Popular opinion, at least according The Economist's survey, is highly dissatisfied with executive pay outcomes.

                                                                                                                  (2.) See the seminal contribution of Mirrlees (1976). Holmstrom (1982) and Laffont and Martimort (1982) describe contributions to agency theory. Further theory and evidence on the risk-incentive trade-off is provided in Prendergast (2002).

                                                                                                                  (3.) There are, in fact, very few women CEOs (Bertrand, 2009; Bertrand and Hallock, 2001).

                                                                                                                  (4.) A little more formally, the bonus, B, can be written as B = 0 if 0 〈 PPmin, B = a + bP if PminPPmax, and B = Bmax if PPmax, where B is the bonus payment, P is a typically an accounting performance variable, and the superscripts max and min are, respectively, the maximum and minimum. The constant term a is the minimum bonus and b is the incentive parameter. A bonus planner can modify incentives and CEO behavior by adjusting each of these. A higher base bonus is represented by increasing a or greater pay-for-performance by increasing b.

                                                                                                                  (5.) In this example, suppose S = X = $50, stock volatility is 30 percent, the annual risk-free interest rate is 3.0%, the option maturity term is set at 7 years, and the stock's dividend yield is 2.5 percent. Inserting this information into the modified Black-Scholes pricing formula gives a value of $13.46.

                                                                                                                  (6.) To see this, if one holds constant all the input variables in the pricing equation and changes S and X (always setting S = X because the option is granted at the money), then the ratio of the Black-Scholes estimate to the face value (S) is constant. The values of the other variables correspond to terms that might be found in an option contract given to an executive.

                                                                                                                  (7.) The option delta (or hedge ratio) is the derivative of Black-Scholes call option value with respect to the asset price. It can be thought of as a weight, varying between zero and one, reflecting the likelihood that the stock option will end up in the money.

                                                                                                                  (8.) This also raises other challenges. A complete picture of executive incentives would require full information of CEO wealth. But the benefits of providing this information publicly to investors, say, in the proxy statements, need to be set against the costs in terms of the CEOs' legitimate rights to privacy in financial matters.

                                                                                                                  (9.) This section draws on Conyon (2006).

                                                                                                                  (10.) Crystal (1991, p. 9) remarks: “Executive compensation in the United States did not go out of control simply through some random process; it went out of control because of the actions—or inactions—of a number of parties. The first culprits in what will be a litany of culprits are compensation consultants.”

                                                                                                                  (11.) For example, business schools are populated with MBA students with goals of competing for such positions.

                                                                                                                  (12.) This section draws on my joint research with Kevin Murphy, Nuno Fernandes, Miguel Ferreira, and Pedro Matos; see Conyon et al. (2010).

                                                                                                                  (13.) New evidence in this area is beginning to become available. Important sources of information on the financial crisis, especially in relation to corporate governance, include the Social Science Research Network ( and the European Corporate Governance Institute (

                                                                                                                  (14.) Results varied by political preferences. About 75 percent of Democrats were in favor of government action on bank pay, compared to 37 percent of Republicans in favor. Source:

                                                                                                                  (15.) A similar negative correlation is documented between measures of accounting performance and incentives. Incentives are defined as the dollar change in the value of the CEO's equity portfolio for a percentage change in the stock price; or alternatively as the percentage ownership of shares and options.

                                                                                                                  (16.) Fahlenbrach and Stulz (2011) also investigate whether alternative measures of incentives are correlated with inferior long-term performance. They find no relation between financial performance and CEO equity risk, or between bank performance and the ratio of bonuses to cash compensation. Equity risk was measured in two ways: (1) as the dollar change in the value of the CEOs equity portfolio for a percentage change in the volatility of the option, and (2) the percentage change in equity values for a percentage change in the stock price volatility. The authors also find no difference in their general pattern of empirical results between firms receiving funding from TARP and other non-TARP firms.

                                                                                                                  (17.) A similar pattern emerges for the averages, too. In Europe, average CEO bonuses fell about 30 percent in banks and 16 percent in nonbanks, whereas in the United States, average bonuses fell by about 70 percent in banks and 15 percent in nonbanks.

                                                                                                                  (18.) Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub.L. No. 111-203, 124 Stat. 1376 (2010).